Last we met, ECRI was explaining how their weekly leading indicator was being used to justify positions and forecasts that were neither useful nor appropriate for the indicator. At least, according to ECRI, the creators of the WLI. Subsequently, Mike Shedlock, along with several others, challenged their data series and WLI.
This morning, Lakshman Achuthan and Anirvan Banerji, co-founders of ECRI, respond to the criticism, misuse and misinterpretation of ECRI’s Weekly Leading Indicators:
In recent months, ECRI’s Weekly Leading Index (WLI) has enjoyed a good deal of newfound publicity. We appreciate the attention, since the WLI is meant to help decision makers navigate the business cycle, and has done so quite effectively over the course of the last few recessions and recoveries. We’re therefore pleased that many more people are now aware of this decision-making tool.
However, the attention to the WLI has been accompanied by a deluge of misinformation which we tried to address in an article titled, Weekly Leading Indicators Widely Misunderstood. We’re concerned that, since then, further unenlightened commentary is still creating such confusion about this very useful tool that it will undermine confidence in its efficacy. We therefore address the main lines of criticism.
Criticism from the Bulls
One major line of attack comes from bulls and/or sell-side analysts and Wall Street economists whose sanguine forecasts may have been challenged by the WLI. Some of them have sought to discredit the WLI by finding various ways to explain why it should be disregarded. A number of analysts with such axes to grind have decided to find fault with its composition.
For example, a few have claimed that the WLI is driven mostly by stock prices, or, more generally, that it is overweighted by market data. Emblematic of this line of criticism is a recent Wall Street Journal article claiming that 5 of 7 WLI components are financial market indicators. Conversely, an analyst quoted in Barron’s claims to have “reverse engineered” the WLI, leading him to conclude that the WLI puts “a large weight” on housing:
These could all be cogent critiques – had they been valid. We therefore wish to set the record straight – hopefully, once and for all.
As for the supposedly heavy influence of stock prices on the WLI, please note that, during the first two weeks of July, the WLI was flat (and its smoothed growth rate kept falling) while stock prices rose. As for the assertion that 5 of 7 WLI components are financial market indicators, let us make an unambiguous declaration: this is flat-out false. Interestingly, although we informed the Wall Street Journal reporter concerned that his information was wrong, he didn’t see fit to run a correction on the story, which most readers therefore believe to be factually correct.
As for the “reverse engineering” of the WLI, the conclusion that it puts a “large weight” on housing is plain wrong. We can only infer that the model used to “reverse engineer” the WLI was grossly misspecified.
Criticism from the Bears
Opposing criticism comes from the super-bears, who were cheered no end by this year’s fall in the WLI, having been badly blindsided by the earlier 80% rally in stock prices since the March 2009 low. To them, the WLI’s downturn this year may have represented the promise of ultimate vindication.
Some prominent voices representing this group of analysts, who had hurled scorn on the WLI on its way up last year, seem to have decided that the WLI is their new best friend. One widely-quoted commentator famously declared that the WLI has always been correct in calling a recession whenever its growth rate fell below a specific threshold. Many who read this concluded, in essence, that the WLI was infallible as a recession predictor. All we can say is that we’re flattered, but if there’s anyone who thinks that an infallible economic indicator actually exists, he should get in touch with us right away, as there’s a wonderful bridge we’d like to sell him.
It’s true enough, based on the four decades of publicly available data, that WLI growth has never dropped this far without a recession. What most don’t know – apart from the fact that the WLI growth rate shouldn’t be used to predict recessions in the first place – is that, based on two additional decades of data not available to the general public, there are a couple of occasions (in 1951 and 1966) when WLI growth fell well below current readings, but no recessions resulted.
Some bearish analysts, frustrated by our refusal to make a recession call thus far, have been hurling aspersions on ECRI’s agenda and motives, insinuating, among other things, that we’re ignoring our own indexes because we’re beholden to the Wall Street establishment, or to the political establishment, or to the academic establishment – or that we’re simply too timid to make a bold call. Anyone who’s familiar with our record is aware that, not only have we made many out-of-consensus predictions, but that, over the years, our views have irked each of the above interest groups, and a number of others for good measure. In fact, while a bit louder, the pattern of accolade and abuse we’ve received over the past year is entirely typical: it’s quite normal for ECRI to be alternately glorified and vilified by bulls and bears, liberals and conservatives, as the objective data swings up and down over the course of the economic cycle.
A prominent bearish analyst, who’s spent some time highlighting the WLI in recent months, penned gracious words for those who heeded the rising WLI last year, writing: “for those folks that paid attention, like Jim Grant, kudos to them.” What he likely does not understand is that Mr. Grant’s transformation from bear to bull last year wasn’t based on just the WLI.
Unlike analysts writing uninformed critiques of the WLI, Jim Grant has followed the work of our research group for decades. In his own publication, highlighting his shift to a bullish stance last year, he tagged our views as “the exception to the predictive consensus,” and quoted extensively from ECRI’s reports and his discussions with us to justify his change of mind, citing what he described as ECRI’s “table-pounding” missive sent to clients in March 2009, the week after the market hit bottom. In Grant’s words, “The implication could not have been clearer that a market rally, when it started, would be no sucker’s affair but the real McCoy.” Yet, his representation of ECRI’s views was nuanced, unlike the recent commentary on the WLI: Despite their cyclical upturns, he noted at the time, ECRI’s leading indexes “make no representation … that a strong recovery will deliver a strong and sustained expansion.”
What’s amazing to us is that none of the analysts who’ve written reams about the WLI this year have read ECRI’s reports or spoken with us. In every single instance, they’ve misinterpreted the WLI to suit their own agendas, with scant regard for objective analysis. Many of them mistakenly assume that the WLI was constructed based on the back-fitting of data, thus justifying their own efforts at fitting the WLI data to past history.
In the face of such widespread disinformation, we must assert that the WLI isn’t being distorted in any manner by its components that would make its movements less meaningful than usual. Nor will we abandon our rigorous and objective approach to recession forecasting that is based on much more than the WLI, which is one small piece of a large array of leading indexes. This includes the U.S. Long Leading Index (USLLI), which is quite distinct from the WLI, and is very different in composition – which is what makes ECRI’s leading indexes so powerful collectively.
ECRI’s Agenda: Getting the Call Right
Like everyone, ECRI certainly has an agenda and motivations, but they aren’t what critics ascribe to us. In fact, we’ve always been quite open about our agenda and the source of our funding, which inevitably helps shape our motivations. In fact, as an independent research institute with a broad client base, we’re beholden to no interest group, including academia. However, in order to assure ECRI’s continued viability, we do need to make forecasts that are both accurate and timely enough to be useful to decision-makers. Along with the preservation and advancement of the tradition of classical business cycle analysis handed down to us over three generations, that’s the entirety of our agenda, period.
In our book, we’ve described in detail how we look for pronounced, pervasive and persistent cyclical swings in multiple leading indexes in order to make a recession or recovery call. This is a disciplined, objective process we’ve always followed, allowing the chips to fall where they may. Our forecasting approach hasn’t changed, regardless of the torrent of criticism directed at ECRI or the WLI by interested parties.
The U.S. economy is now firmly in the grip of the economic slowdown that we’ve been predicting at least since January. The reality is that, historically, a little more than half of such slowdowns have culminated in recession. Thus, we already knew back in January that, once this slowdown began, there would be a significant risk of recession.
However, a recession is hardly baked in the cake, which is why we aren’t making a recession call at this time. Simply put, we don’t predict the predictors. If we see our collection of leading indexes (including the USLLI, which turns ahead of stock prices) swing decisively toward the recession track, we’ll make a clear recession call. Until then, we’ll keep monitoring our leading indexes, as we’ve done for decades.
Lakshman Achuthan and Anirvan Banerji, co-founders of ECRI